Andrew Wilson: History can't help an economy in uncharted waters

Published on Saturday 1 August 2009 14:15

IF YOU are trying to make sense of the current economic landscape you face a tough task. We have "never been here before" in terms of the current environment and experimental policies of governments and central banks around the world. So history is of less help than usual.

Meanwhile, following their meltdown in 2008, stock markets continue to be volatile. For example, the FTSE 100 has appreciated by 30% from its March lows, but has also witnessed a 20% fall during one period of 2009. In the three-year period between 2003 and 2006 the biggest fall over any period was just 6.5%. Sentiment remains fragile and changeable. The challenge is to get a clearer perspective and avoid making the wrong decisions because of the high levels of volatility.

It is not difficult to imagine a possible scenario whereby equities grow by high single digits for the next few years. Indeed, investments in general could perform well from here. However, a fair degree of caution is needed. For example, high-yield bonds have done an awful lot already and may need to consolidate, and default rates could be higher than usual for investment-grade corporate bonds.

The recent recovery in the performance of investments has been driven by encouraging growth in China and better than expected corporate earnings in the US. Chinese growth has been aided by extraordinary amounts of borrowing, which leaves a big question mark over how volatile these increases in Chinese asset prices are going to be.

In the case of US corporate earnings, 75% of US companies have beaten analysts' estimates for the second quarter. However, just as in other regions, much of this has come from cost-cutting. US companies have been particularly aggressive here and only 50% of firms actually beat sales forecasts. So, none of this is particularly convincing yet.

Meanwhile, this is the first recession since the Great Depression of 1929 to have destroyed all the jobs growth from the previous business cycle. It is estimated that only 11% of the US stimulus package money will have been spent by the end of the year, and in any case this package is, to an extent, being countered by budget-cutting at the state level.

Therefore, those who lost their shirts in the technology bust of 2001, and were unfortunate enough to repeat the trick with their houses in 2007 and their pension plans in 2008, could continue to feel the squeeze. That said, fires eventually burn themselves out, and with home sales up three months in a row and the cost of living having its biggest drop in 60 years, it is entirely possible that US GDP will start to follow lead indicators up, albeit from a low level.

It is easy to be gloomy about the UK, and especially government finances. This is in part due to a basic balance sheet disconnect, ie what the country has earned via taxes should bear some resemblance to what it spends. The reality has been somewhat different and an astonishing public sector binge has produced questionable productivity gain.

Another worry is that living standards in general cannot be expected to be sustained beyond the productivity of an economy. This is all to come for the next UK government following an election likely to take place in 2010. Winning may prove to be a poisoned chalice. That said, by then the economy should at least have pulled out of its nosedive, currently five successive quarters of negative GDP growth and counting.

Investors have reacted by putting record amounts into emerging markets, following this sector's outperformance of developed markets since late 2008. The result is that emerging markets now look relatively expensive, although such flows can be a self-fulfilling prophecy for a while. However, Asia and emerging markets still look a good long-term bet and the reporting season has gone incredibly well under the circumstances. Interestingly, it seems that institutional investors have not followed their retail contemporaries into equities and other risk assets, which means there is potential support for markets should they start to move.

Overall, we are optimistic on the outlook for shares and investments over a reasonable time frame, although there is likely to be continued volatility. Markets will have some pause for thought in due course, if only when central banks eventually take their foot off the gas and interest rates start to rise.

I mentioned at the outset that we have "never been here before". This is important. Nobody can predict the future with any degree of certainty at the best of times. While assets may look cheap, or may look expensive, they will never rise or fall in a straight line. This is why managing risk and volatility is crucial, and this can best be achieved through a genuinely diversified multi-asset class portfolio, where all assets have the potential to be rewarding in the medium to longer term.

Andrew Wilson is head of investments at Towry Law